Many retirement savers look to age 59½ or 65 as key dates in their retirement plans, but 70 is also a milestone: It's the age when those who own traditional IRAs or qualified retirement plans must begin taking required minimum distributions (RMDs). RMDs can have several effects on the taxpayer’s budget and tax bill, and some of the possible costs that come with these distributions can stay hidden until tax time.
Here’s what you need to know in order to financially prepare for your 70th birthday. (For more, see: Avoiding Mistakes in Required Minimum Distributions.)
The Real RMD Age
The first thing you need to understand about reaching age 70 is that it is not the actual age at which the IRS requires you to start taking mandatory minimum distributions. The exact date is April 1 of the year after the year in which you turn 70½. Therefore, if your birthday comes in the second half of the year, you won’t be 70½ until the following year and won’t have to take RMDs until April 1 of the following year.
For example, if you will turn 70 in October 2016, then you won’t be 70½ until March 2017. But you can still wait until April 1, 2018 to begin taking distributions. However, the amount that you will have to take at that time will be higher than if you started taking them right at 70½ in order to make up for the delay.
You can also delay taking distributions from your 401(k) plan or other qualified plan if you are still working (and can also continue making contributions) as long as this is permitted by the plan and you don’t own at least 5% of your company. However, this does not apply to SEP or SIMPLE plans. You can still contribute to these but must also take RMDs. (For related reading, see: How to Calculate Required Minimum Distributions.)
When you have to start taking RMDs, you need to know exactly how it can affect your tax bill. If you’re lucky enough to have plenty of deductions and credits that exceed your current taxable income every year, you may not have an actual tax bill when your RMDs are added in. However, if this is not the case for you, you need to know that your RMDs will not only be reported as taxable income, but may also affect the taxation of your Social Security benefits and your eligibility for deductions and credits that are phased out at certain levels of income.
“Taking an RMD may bump you into a higher income threshold that forces you to pay more taxes on your Social Security income. Depending on your level of income, $0.50 for every $1 of Social Security may be taxed or $0.85 of every $1 may be taxed. If you are right on the bubble of moving into the $0.85 category, an RMD might just push you over,” says Mark Hebner, founder and president of Index Fund Advisors, Inc., in Irvine, Calif. If you have other substantial income, such as from a job, then your itemized deductions may also get partially or fully phased out.
One way to avoid this dilemma is to convert your traditional IRA and qualified plan balances to a Roth IRA before you reach your RMD deadline. Of course, this will generate additional taxable income in the years that you do the conversions, but this also gives you control of when you will pay your taxes and how much you will pay. You can convert just enough each year to keep you in your current tax bracket, and when you retire, you won’t have to take any RMDs and can hopefully end up in a lower tax bracket.
The ideal time to do this would be after you stop working and have a much lower AGI. You may in fact be able to partially or fully escape taxation on your conversion balance altogether if you will be eligible for deductions or credits that will otherwise go unused – because there would be no other taxable income to credit them against. (For related reading, see: Taxes on Retirement Assets: How to Pay Less.)
If you have more than one traditional IRA or qualified plan from which you will have to take RMDs, you can aggregate your distributions so that you are taking them all from one account. This can be advantageous if you don’t want to liquidate the holdings in one of your accounts and have unused cash lying around in another. You can take an amount that satisfies the RMD rule for both accounts from the cash account.
The Charitable Loophole
The tax rule that allows all RMD payments to be excluded from your income via charitable donation has become permanent in 2016. “With a qualified charitable distribution (QCD), clients have the chance to make a charitable contribution directly from their IRA. The distribution counts towards the required minimum distribution, but it doesn’t count toward taxable income,” says David Hunter, CFP®, president of Horizons Wealth Management, Inc., in Asheville, N.C. You cannot take constructive receipt of the money yourself; it has to go directly to the qualified charity from your IRA or qualified plan without coming to you first.
This is superior to taking the distributions and then donating them to charity because it does not require itemization in order to be excluded from your income. There is also no limit to the amount that you can exclude in this manner; if your RMDs equal $100,000 and you want to give the entire amount to charity, you can do so under this rule every year. (See How to Use the QCD Rule to Reduce Your Taxes.)
The Bottom Line
Age 70 marks the time that you will have to start thinking about your required minimum distributions if you have not done so already. But you would be wise to start planning for this factor much sooner if your RMDs are going to be substantial. For more information on RMDs and how they will affect you, download Pubs. 575 and 590 from the IRS website. (For related reading, see: An Overview of Retirement Plan RMDs.)